Stock market plunges 54%, stagflation on the horizon? Federal Reserve simulates extreme scenario of AI bubble burst

The Tongtong Finance APP notes that the Federal Reserve annually develops a “Severely Adverse Scenario” to conduct stress tests on the financial system. Here is the 2026 Severely Adverse Scenario:

The 2026 Severely Adverse Scenario is set as follows: due to a sudden decline in risk appetite, triggering a global severe recession, leading to sharp declines in risk asset prices, falling risk-free rates, and highly volatile financial markets. In the first three quarters of this scenario, the stock market drops about 54%, while the VIX spikes and peaks at 72% in the second quarter. These conditions also cause corporate bond spreads to widen to 5.7 percentage points. The resulting chaos suppresses household demand for goods and services, prompting companies to significantly cut employment and investment, with the economy and asset prices recovering slowly. The U.S. unemployment rate will rise from 4.5% at the end of Q4 2025 by 5.5 percentage points, reaching a peak of 10% in Q3 2027. The sharp contraction in economic activity leads to a housing market crash, including a 29% decline in nominal home prices and a 40% drop in commercial real estate prices.

Essentially, the Fed hints that a “sudden decline in risk appetite” could lead to a severe recession—its transmission pathway appears to be through negative wealth effects from a stock market bubble burst, with unemployment soaring to 10%, subsequently triggering a systemic credit event, and ultimately causing a housing bubble collapse.

This is also partly the outlook of some pessimistic analysts for 2026—a recessionary bear market accompanied by an AI bubble burst.

It is important to note that the Fed develops both a Severely Adverse Scenario and a Baseline Scenario each year. In almost all cases, the Baseline Scenario has proven correct—except in 2000 and 2008; in those two instances, the Severely Adverse Scenario ultimately became reality. Unfortunately, the macroeconomic situation in 2026 seems very similar to that of 1999-2000 and 2007-2008.

Baseline Scenario

First, the Fed’s baseline scenario for 2026-2029 envisions moderate economic growth, stable unemployment, and gradually declining inflation—what is often called the “Goldilocks” scenario.

According to this “Goldilocks” scenario, the Fed expects: 1) 3-month Treasury yields will fall from 4.0% at the end of 2025 to 3.1% by the end of 2029; 2) 10-year Treasury yields will gradually decline to 3.9% by 2029; 3) the stock market will rise by an average of 4.3% annually until 2029; 4) nominal home prices will decline before Q1 2027 and then gradually rise until 2029; 5) commercial real estate prices will increase by 4.3% annually.

Even in the Fed’s “Goldilocks” baseline scenario, there is little comfort; stock market performance over the next three years is expected to be modest, with an annual increase of only 4.3%. The Fed is likely aware of the bubble-like Shiller P/E ratio; although the baseline scenario does not predict a bubble burst, it forecasts very mild performance, barely outperforming the 3-month U.S. Treasury.

Severely Adverse Scenario

The Fed’s Severely Adverse Scenario predicts a severe recession, with unemployment rising to 10% and inflation dropping to 1.1%—a typical deflationary recession.

Correspondingly, in this scenario, the Fed would cut rates close to zero, the 10-year yield would fall to 2.3%, stocks would plummet by 54%, and real estate prices would collapse. Credit spreads would widen sharply—similar to the 2008 scenario.

Global Stagflation and Dollar Appreciation

However, the 2026 global Severely Adverse Scenario is characterized by commodity-driven stagflation.

The 2026 global market shock features rising inflation expectations, whereas last year’s global shock saw inflation expectations decline.

In the current global shock, yields on bonds of all maturities have risen, whereas last year’s saw yields fall, with short-term yields declining more than long-term yields.

In the 2025-2026 global shocks, the U.S. dollar appreciated against most major currencies.

During the current global shock, commodity prices such as gold, oil, and natural gas rose due to inflation pressures, whereas last year’s shock saw commodity prices fall.

In the 2025-2026 shocks, credit spreads widened and stock prices declined.

How likely is the Severely Adverse Scenario?

The trigger for the U.S. adverse scenario is a “sudden decline in risk appetite.” So, what could cause investors to seek safety in 2026?

Additionally, the trigger for the global adverse scenario is commodity-driven inflation. What could cause oil and gold prices to rise in 2026?

First, the market is facing an unfolding AI bubble burst, temporarily masked by capital rotation into “value stocks.” The AI bubble burst is twofold: 1) large-scale companies depleting cash flows and borrowing to finance AI capital expenditures, while investors question the returns; 2) AI applications disrupting many industries, including software. Ultimately, both will lead to a credit event, with Blue Owl’s situation unfolding. The Fed’s adverse scenario predicts that the AI bubble burst could trigger a recession through negative wealth effects—this is highly plausible.

Second, investors are concerned about geopolitical tensions, possibly an imminent U.S.-Iran war, which could cause oil prices to spike, capital flight into gold, and ultimately trigger a global recession. Given current information, Iran’s reluctance to fully abandon uranium enrichment makes this scenario quite likely.

Therefore, the likelihood of the Fed’s severe adverse scenario occurring in the U.S. and globally is alarmingly high.

Impacts

Despite the S&P 500 approaching record highs, the VIX index is near 20, indicating that market participants are preparing for volatility.

Note that the trigger for the Fed’s Severely Adverse Scenario is merely a decline in risk appetite—meaning even a benign initial adjustment could escalate into a recession and a stock market crash comparable to 2008.